Academic journal article Journal of Business and Behavior Sciences

The January Effect: A Test of Market Efficiency

Academic journal article Journal of Business and Behavior Sciences

The January Effect: A Test of Market Efficiency

Article excerpt

INTRODUCTION

The existence of the January effect has been frequently debated in finance literature for many decades. The January effect occurs when an investor obtains abnormally large returns on small cap stocks at the turn of the calendar year. In order for this to happen the investor buys stock in a small or underperforming company at the end of the current year and then sells the stock when its price rises in January of the new year.

According to Fama (1970), market efficiency claims that at any given point in time stock prices reflect all available information in the market. There are three different levels of market efficiency: strong form efficiency, semi-strong form efficiency, and weak form efficiency. When a market is strong form efficient an investor should not be able to earn an above average rate of return by acting on either public or private information. When a market is semi-strong form efficient an investor should not be able to earn an above average risk-adjusted rate of return based on all public information. When a market is weak form efficient the market reacts so fast to past information that no investor can use yesterday's news to earn an above average rate of return or a return higher than that of the S&P 500 Market Index. Many investors in the past have been able to earn an abnormal rate of return by using private information (or insider trading), which suggests that the market is not strong form efficient. Is the market weak form efficient with respect to the past information hypothesized to cause the January effect? To research this question, this study analyzes stock price returns 60 days before and 30 days after the last trading day for three consecutive years to see if investors can earn an abnormal rate of return in January of the new year. Specifically, to test the weak form efficient market hypothesis, this study analyzes stock price returns for under-performing firms 60 days before and 30 days after the last trading day of years 2010, 2011, and 2012 to test for the hypothesized January effect.

The purpose of this study is to test whether an investor can earn abnormal risk-adjusted returns by selling stocks in January that were purchased when underperforming at the end of the previous year. This study tests to see if, based on solely past information, an investor can earn an abnormal return at the beginning of the new year.

For this study a sample of 90 companies was examined. Thirty of the worst performing companies were examined for each year 2010, 2011, and 2012. Each 30 firm sample was selected from those companies identified as the largest prior year losers 2010 through 2012. This study tests the weak form efficient market hypothesis by examining the rate of return that stocks earn 60 days before and 30 days after the last trading day of each sample year.

LITERATURE REVIEW

Investors in the stock market typically accept the existence of the January effect, but some question its validity. Sydney B. Wachtel (1942) observed the effect on stock prices in 1942 and is responsible for naming it the January effect. One of the explanations that professionals in the field of finance believe could explain the January effect centers around tax-motivated transactions. Based on this explanation, it follows that logical investors would engage in tax-loss selling at the year-end to mitigate negative tax consequences (Reinganum, 1983). Then when they receive their year-end bonuses they re-enter the market in January pushing the prices higher.

Another explanation discussed in the field of finance is the window dressing hypothesis. This hypothesis says that at year-end portfolio managers sell losing stocks to make their portfolios look better. Portfolio managers who want to attract more customers sell off losing stocks so that their year-end report shows only profitable stocks. Then in January portfolio managers reinvest in lesser- known small, riskier stocks with the hope of making a profit, thus raising the January prices (Haugen & Lakonishok, 1988). …

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